NGEN, INC. (NGEN) - Description of business

Company Description
Our company is based on the vision of providing a higher quality of healthcare through advanced diagnostic products. Our business strategy is to assemble the companies, products and knowledge base to become a leading supplier of the technologies and products that will help drive a new era of personalized medicine. We were early to recognize that the adoption of personalized medicine is dependent on the advancement of diagnostic technologies. The commercialization of our products and technologies will help bridge the gap between early-stage scientific research and actual clinical practice. We are developing several product lines that are directly targeting specific markets within the advanced diagnostics field that have significant potential for revenue growth. We see recent successes and a growing capability in the clinical laboratories ability to perform accurate advanced diagnostic testing as a strong validation of our strategy. In addition, the U.S. Food and Drug Administration (the “FDA”) has recently released guidance encouraging the generation of more pharmacogenomics data and molecular diagnostic testing during drug development and clinical trials, and before the use of medications. We believe these applications of advanced diagnostics will help build demand for our products and technologies. In the last twelve months we have introduced several new products and believe they present significant opportunities for Nanogen to increase its revenues in 2007 and beyond. These new products represent important milestones for our company and the implementation of a sustainable, multi-product business model that over time will demonstrate improved financial performance. We released several Analyte Specific Reagents (“ASRs”) including multiplexed reagents for the detection of the 23 most common genetic mutations related to Cystic Fibrosis and a series of real-time molecular reagents for infectious diseases. Our 2006 annual revenues of $26.9 million more than doubled as compared to 2005. In 2006, we used $38.4 million of cash in operating activities and our multi-product commercialization strategy continues to require a significant investment. We believe we will continue to use cash and have net losses until revenues from our product offerings climb substantially. To continue to fund our commercialization strategy, in 2006 we raised $15.0 million from issuing equity securities to a corporate investor and $5.5 million from our equity line and also financed certain future royalty streams for an additional $20.0 million of cash. We believe that we will have the ability to sell a sufficient amount of securities to investors to continue our strategy of expanding our product pipelines by acquiring companies or assets and supporting our on-going internal product development. As a part of our on-going long-term strategy, we actively and selectively seek to acquire companies with complementary products and strong intellectual property positions. We also specifically target companies with existing product lines that complement and add depth to our product portfolio that are or can be turned into cash flow positive entities when integrated into our company. In addition, we are developing an internal infrastructure that allows us to rapidly integrate acquired businesses or product lines into our existing sales, distribution and administrative functions. We have recently acquired or invested in the following companies:   •   On February 6, 2006, we acquired the rapid cardiac immunoassay point-of-care test business of Spectral Diagnostics Inc. (“Spectral”). This acquisition expanded our menu of products available for point-of-care customers. The acquired products include rapid tests for levels of CKMB, Myoglobin and Troponin, all of which are frequently used in cardiac care. In addition, we acquired an ability to manufacture these and other point-of-care products. The total purchase price of approximately $7.7 million was comprised of $4.8 million in cash and 975,193 shares of our common stock. The results of these acquired business operations were consolidated within our financial statements beginning February 6, 2006.   •   On May 1, 2006 we completed the acquisition of the diagnostics division of Amplimedical S.P.A. (“Amplimedical”), which is a manufacturer and distributor of molecular diagnostic products. Based in Italy, Amplimedical has been active in the European and other markets since the early 1990s with its molecular diagnostic reagents. Nanogen and Amplimedical have shared a business relationship for approximately five years, during which time Amplimedical has been a distributor of Nanogen’s NanoChip ® Molecular Biology Workstation and NanoChip ® 400 instrument systems in Italy. We believe this acquisition will allow our molecular diagnostics business to further expand in Europe by providing additional resources and scale. Amplimedical’s portfolio of real-time molecular diagnostic test kits are all CE marked for in vitro diagnostics. Amplimedical’s diagnostic test kits also include multiplexed reagent kits, sold in Europe, such as the CE/IVD-marked set of reagents used to detect mutations in the GJB2 gene for the diagnosis of hereditary deafness and a research-use-only set of reagents to test for genetic causes of beta thalassemia, a type of inherited blood disorder that can cause anemia. The purchase price was approximately $9.9 million that was comprised of a $2.1 million payable secured by a letter of credit, a $6.9 million promissory note convertible into our common stock, and $0.9 million in transaction costs. On June 30, 2006 we paid the promissory note in full by issuing Amplimedical 2,886,935 shares of our common stock at a $2.63 per share conversion price and incurred no interest charges.   •   In a series of investments from July 2005 through June 2006, we invested approximately $3.0 million to purchase 29.7% of the outstanding stock of Jurilab LTD (“Jurilab”). In addition, we have the option to purchase the entire company at a not-to-exceed price through December 31, 2007. By investing in Jurilab, a development stage research and development company, we gained access to technologies related to certain gene markers. We believe that this investment strategy is an effective use of our cash because it provides us approximately two years to evaluate Jurilab’s technology for potential commercialization and integration into our product lines before we commit to purchasing the entity. We are incorporated under the laws of the state of Delaware and our stock is listed on the Nasdaq Global Market under the symbol “NGEN.” Our corporate offices are located at 10398 Pacific Center Court, San Diego, California 92121. Our main telephone number is 858-410-4600. We make available through our internet website our code of business conduct and ethics, annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to these reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission. Our internet address is The information contained in, or that can be accessed through, our website is not part of this Annual Report. Technology and Customers Technology Our diagnostic technologies focus on the identification of circulating proteins associated with specific diseases or on the nucleic acid sequences and gene variations associated with both genetic conditions and infectious diseases. We believe that our research will contribute to a new healthcare paradigm where disease is diagnosed and understood at the personal level. We believe that this will lead to shifting the focus of medicine to be increasingly proactive as well as being increasingly specific to the individual patient. Our tests will provide physicians with the information they require to tailor specific therapies to the individual patient. In support of this objective, we have developed a variety of diagnostic products for both the relatively simple and complex testing required to render disease specific molecular information accessible to researchers and clinicians. Below illustrates how our platform technologies address our customer’s requirements for advanced diagnostic products: Potential customers addressed by our technologies:       Advanced Research( Universities, researchfacilities, etc .)   Clinical Laboratory ( CLIAcertified central laboratoriesand clinical researchlaboratories )   Point-of-care ( Emergencyroom or urgent caresettings )           Molecular testing platforms ( Instrumentation )             Molecular Reagents ( Reagents, ASRs , Custom Assays )                                   Point-of-Care Tests ( Test Kits and Instruments )   Advanced genetic markers As illustrated above we have four categories of advanced diagnostic technologies: 1) molecular testing platforms 2) molecular reagents 3) point-of-care tests and 4) advanced genetic markers. 1)    Molecular Testing Platforms (Instrumentation) For our customers that need to develop or perform more complex testing than is available with real-time instruments, we have developed the second generation NanoChip ® 400 system. This system is based on our proprietary “lab on a chip” detection technology that allows testing for multiple gene markers or mutations on one test site. Using our open system architecture, researchers and clinical laboratories can readily develop assays to test multiple genetic mutations for multiple patient samples and to perform them on an automated system. Our first generation system, the Molecular Biology Workstation has been discontinued and while we continue to support existing customers, the system is no longer being marketed or sold. 2)    Molecular Reagents (ROU Reagents, ASRs, Custom Assays) Molecular reagents encompass real-time PCR products and molecular reagents. The real-time products are platform independent and include custom designed products for the research market and ASRs which are sold to laboratories certified under the Clinical Laboratory Improvement Amendments of 1998 (“CLIA”) to develop, optimize and validate tests for clinical uses and CEIVDs, products that are registered for sale within the European Union. These products amplify disease specific nucleic acid sequences for analysis or identification in a simple test with rapid turn around. The US customers for this product line are primarily advanced research and clinical laboratories that test for single markers or mutations in genes. We also offer reagents for more complex mulitplex testing. These reagents provide laboratories the capability to test a patient sample against multiple targets. We currently offer multiplex reagents for genetic testing including respiratory viruses (RVA), blood clotting (Factor V/II), cystic fibrosis, and warfarin metabolism. The US customers for multiplex reagents are primarily research and clinical laboratories that test for infectious disease and genetic disease conditions. In Europe, the customers are generally government entities contracting for diagnostic tests through tenders. 3)    Point-of-Care (Test Kits) Our point-of-care tests consist of highly specific tests for identifying proteins that play a role in specific diseases. By identifying the level of specific proteins present in a patient sample, doctors can more accurately diagnose and monitor the progress of specific diseases. On February 6, 2006, with our acquisition of Spectral’s point-of-care assets, we acquired several revenue generating rapid cardiac immunoassay tests that broadened our menu of products available for point-of-care customers. The acquired products include rapid tests for levels of CKMB, Myoglobin and Troponin I, all of which are frequently used in cardiac care. In addition, we acquired the ability to manufacture these and other point-of-care products. Also in 2006, we received a 510(k) clearance for a rapid diagnostic test for CHF using plasma samples. This product has not yet been introduced to the market. Our research and development efforts are focused on developing a test for congestive heart failure using whole blood samples. The customers for our point of care tests are generally emergency rooms and critical care units. Over time, we believe our technologies will help to move many of these tests from the clinical reference lab to the point-of-care settings such as the emergency room. 4)    Advanced Genetic Markers With our investment in Jurilab we gained access to a large database of advanced genetic markers created by studying the genetic patterns of a founder population in East Finland. This database provides insights to the correlation of genetic patterns as prognostic indicators of disease. We expect this collaboration to enhance the development and commercialization of our technology platforms by adding proprietary solutions to evaluate and diagnose disease. In May 2006, we entered into a collaboration agreement with Jurilab, where Jurilab would identify and validate new prognostic markers for Type II diabetes with certain milestone payments of up to €950,000 or approximately $1.2 million. As of December 31, 2006 we had paid Jurilab €550,000, or approximately $715,000, in milestone payments under this agreement. Customers The customers for our instrumentation, ASRs, reagents and custom assays are clinical research laboratories, high complexity CLIA certified laboratories and government-based healthcare facilities. In the United States, the Food and Drug Administration (the FDA) regulates most diagnostic tests and in vitro reagents marketed as test kits as medical devices. The FDA also considers ASRs to be medical devices. ASRs are exempt from pre-market approval requirements; however, the FDA restricts the sale of these products to those clinical laboratories that are certified under the Clinical Laboratory Improvement Amendments of 1988, known as CLIA. FDA regulations concerning ASRs are currently undergoing change and we expect to make adjustments to many, if not all, of our ASR products to conform to revised FDA regulations. All products sold in Europe require CE marking. Our customers in Europe are currently serviced through a distributor network in all countries except for Italy which is supported by Nanogen Advanced Diagnostics SrL. Customers for our diagnostics technology and products therefore include:   •   Clinical Laboratories (CLIA certified central laboratories and research laboratories) —These customers offer validated tests to aid physicians in the diagnosis of patients’ conditions. They may either develop reagents internally or may purchase ASRs manufactured under the Good Manufacturing Practices regulations and develop and validate their own tests. Ease of use and throughput is important to these customers.   •   Government-based Healthcare Facilities —These customers are generally hospitals, laboratories or other healthcare facilities in Italy and other European or Middle East countries. These customers generally purchase products via government sponsored tenders which are competitively awarded multiyear contracts for specific diagnostic products.   •   Emergency Room and Urgent Care Facilities —The customers of our point-of-care products are primarily in near patient settings in hospital laboratories and/or emergency rooms. To market and sell to these customers we are required to receive the approval of the FDA through a “pre-market application.” The point-of-care products we acquired from Spectral, in February 2006, have received FDA clearance and are CE marked for distribution in Europe. Our other point-of-care products currently in development, such as the congestive heart failure product, using whole blood samples, will require FDA clearance before we distribute the product in the United States and CE marking prior to distribution in Europe. Products We generate our product sales revenue with our advanced diagnostic product lines that we categorize as: 1) instrumentation, 2) reagents, and 3) test kits. Instrumentation We have developed the NanoChip ® System to address the needs of the molecular diagnostics customer with an objective to become the preferred platform for development of applications for multiplex detection of genetic mutations or infectious disease pathogens by the clinical or clinical research laboratory. We believe our design is unique in the industry as it offers flexibility to the clinical laboratories to match their testing requirements. For example, our instrumentation systems allow the clinical laboratory customer to determine if it is more commercially effective for them to test for multiple genetic mutations on an individual set of genes, or a specific genetic mutation on multiple sets of individual genes or some combination of both. The NanoChip ® 400 consists of a consumable cartridge containing a proprietary semiconductor microchip (the “NanoChip ® Electronic Microarray”), a fluidic and optical instrument, and embedded software that can be programmed by the end-user to control all aspects of microchip operations including processing, detection and reporting. The system has been designed so that once programmed, the end-user need only insert a consumable cartridge into the instrument and all subsequent steps may be handled automatically under computer control. The NanoChip 400 System provides multisample and multianalyte reporting capabilities when creating research or homebrew, clinical tests. This system uses our 400-site or 100-site NanoChip cartridge. In addition, we offer instrumentation products that are designed for use with certain of our point of care immunoassay tests. These include:   •   LifeSign DXpress TM Reader —The LifeSign DXpress™ Reader is a multi-functional portable tabletop camera-based instrument that will be used to read results of in vitro immunodiagnostic assays. This system will be available for sale in connection with the launch of the quantitative CHF test.   •   i Lynx Reader —The iLynx reader is a portable system used in conjunction with the tests acquired in connection with the Spectral asset purchase, including rapid qualitative tests for CKMB, Myoglobin and Troponin, in individual, tandem and in an “all-in-one” testing format used in cardiac care. This system is a qualitative reader with the ability to record useful information relating to the conduct of the tests. Reagents: We offer the following reagent products to customers for use in the development and conduct of molecular tests:   •   NGEN TM Reagents —are reagents designed for use in detecting nucleic acid sequences for specific organisms or genetic mutations. These reagents can be used in connection with PCR amplified patient samples and hybridization detection utilizing fluorescently-labeled probes.   •   MGB Alert TM Reagents —are clinical reagents used for detecting nucleic acid sequences for specific organisms or genetic mutations associated with diseases in a real-time PCR format.   •   MGB Eclipse ® Probe Systems —are reagents used in the development of diagnostics or other research applications in a real-time PCR format.   •   Custom Assays —Our applications scientists develop products to meet our customers’ application needs through specific assay development services. Test Kits: Our point of care products and our molecular reagent products sold in Europe are sold as test kits. In the future, we plan to expand our test kit offerings to include kits for use by US-based customers on the NC400 system. These test kits include:   •   Cardiac STATus ® and Decision Point TM —On February 6, 2006 we acquired several FDA cleared point-of-care products from Spectral that include rapid qualitative tests for CKMB, Myoglobin and Troponin, in individual, tandem and in an “all-in-one” testing format used in cardiac care.   •   StatusFirst TM CHF NT-proBNP —is designed for use with the LifeSign DXpress™ Reader to provide quantitative determination of NT-proBNP levels in human plasma. We are developing a similar product that will utilize whole blood rather than plasma. This potential congestive heart failure test allows for efficient triaging of congestive heart failure patients, while providing accurate diagnostic test results. This product will be manufactured by Princeton BioMeditech (“PBM”).   •   QPCR Alert —molecular diagnostic products that are sold in Europe under CE-IVD regulations for use in infectious disease testing or in testing for certain generic diseases. Our Growth Strategy We plan to grow our business through marketing of our existing products as well as the development and launch of new products. As part of our growth strategy, we will continue to invest in the internal development of new diagnostic products as well as the acquisition of complementary entities or product lines that address large and growing markets. Molecular Testing Platform With the development of our second generation molecular testing platform, the NanoChip ® 400 system, we have focused on penetrating the high value, complex testing requirements of the molecular diagnostics market by creating an open platform that can help automate laboratory testing. This molecular testing platform was designed with an open architecture to facilitate development of molecular tests by our customers and collaborators, driving the growth in assay development far beyond our internal capacities. We believe the NanoChip ® 400 System could transform molecular diagnostics by delivering speed, efficiency and accuracy on a robust platform. We seek to establish our platform as the preferred system for the molecular diagnostics industry in order to reap the benefits of the higher margin profits on consumables. With each placement of the NanoChip ® System, we create a potential source of on-going revenue through the sale of our consumables such as the NanoChip ® Cartridges, ASRs and other products. Reagents and Custom Assays We believe we will increase our revenues by developing proprietary reagents that may be used on the NC400 as well as reagents that do not necessarily require our instrumentation. During 2006, we introduced multiplex reagents for use in CFTR testing and certain pharmacogenomic testing. We also introduced ten real time tests based on our proprietary MBG technology that may be used on multiple instrument platforms. These new products will enable customers to test for various infectious diseases. We believe that offering products for both the multiplexed and real-time markets supports our growth objective by offering customers a choice of technologies for testing. In addition, we will continue to supply our research reagents and our customized assay services in support of customer requests. Test Kits: FDA-cleared and CE marked test kits are an important component of our growth plans. Our acquisition of Amplimedical provides a significant portfolio of real-time IVD kits for use by customers in infectious disease and genetic testing. Our acquisition of the Cardiac STATus ® and Decision Point™ products provides a basis for growth in point of care testing. Emergency rooms and urgent care units represent a significant market for rapid point-of-care testing for cardiovascular conditions. We are in development of a CHF test that once fully developed and cleared/approved by the FDA, European and Canadian regulatory authorities will add to our point-of-care product line. We also plan to develop FDA cleared and CE marked kits for multiplex molecular assays that can be used on the NC400. These products will enable us to expand our addressable market beyond the complex CLIA certified laboratories that can use ASRs in testing applications. Products and Applications in Research and Development Below is a brief description of some of our future products and applications currently in research and development by us or with our collaborators. Instrumentation: In 2007, we are pursuing a two track approach to the development of our instrumentation platforms. The first track is focused on developing the clinical user interface of our molecular testing platform technology to support 510(k) applications for the detection of gene mutations. The second track is continued investment in the open system version of the NanoChip400 ® system that allows our customers to tailor its use to their specific requirements. Also, we continue to work to miniaturize our electronic array technology with the support of several government and privately funded grants. Identification of genetic and infectious disease We are also working to increase our menu of advanced molecular reagents. These reagents consist of our proprietary real time PCR technologies and are sold as ASRs to CLIA certified laboratories for their internal development of highly sensitive assays. During 2006 we introduced ten advanced molecular reagents and we will continue to introduce additional products in the coming years to broaden our suite of real time tests We expect to expand both infectious disease and genetic disease reagents. In conjunction with our investment in Jurilab, we are in the early stages of developing a product to screen patients for a genetic predisposition to develop Type II Diabetes. Point-of-care We are currently developing a point-of-care test for CHF, for use with human whole blood samples, which will give a quantitative reading of NT-proBNP, a marker for CHF, a chronic disease that affects millions of patients each year. The Status First TM product will provide a result in approximately 15 minutes. Working with partners, we expect to add a test for Drugs of Abuse (DOA) and will continue to develop and add products to our point of care cardiac and urgent care menu. We also are actively engaged, with our partner HX Diagnostics, in the development of a pandemic diagnostic product under a contract we received from the CDC. Pharmacogenomics Pharmacogenomics is the science of individualizing therapy based on genetic differences among patients. Certain genes have been shown to be required for the breakdown and elimination of drugs in the body (pharmacokinetics). Individuals metabolize drugs differently based on the individuals’ genetic make up. Certain variations in these genes can result in an inability to process specific categories of drugs, leading to a buildup of toxic chemicals in the body. Other genetic changes can result in extremely rapid breakdown of a drug, limiting the drug’s effectiveness. By determining a patient’s genetic profile prior to prescribing a drug, a physician can reduce the potential for serious or fatal side effects. We believe that the ability of our technology to screen simultaneously for various differences in a patient’s DNA has wide applicability to pharmacogenomics. We are currently developing pharmacogenomic products to help assess the ability of patients to metabolize warfarin and certain other drugs. Research and Development As of December 31, 2006, we had 79 full-time employees in research and development. Our research and development expenses were $26 million in 2006, $22 million in 2005 and $18 million in 2004. These research and development expenses have been directed toward developing products in areas where there is a significant opportunity for a return on investment. Most of our research and development has been conducted at our facilities in San Diego California; Bothell Washington; Toronto, Canada; or Turin, Italy or in collaboration with various partners. Sales and Marketing Our sales representatives are able to recommend the appropriate business solution to meet the needs of our customers by presenting multiple technology and instrumentation options. Sales representatives are trained to find new market opportunities, provide diagnostic solutions to address unmet customer needs, and to provide comprehensive after-sale product support. In addition, our field technical support group provides thorough training and ongoing technical support for our products. We sell our NC400, multiplex reagents, and custom assays in the United States through our own direct sales force. We sell our real-time ASRs and our point of care kits in the US through distributors. On August 9, 2006, we entered into an exclusive distribution agreement with Fisher Scientific to sell our real-time products in the US market. With our acquisition of Spectral Diagnostics, we assumed a relationship with Cardinal Healthcare to distribute our Cardiac STATus, Decision Point, and i-Lynx point-of-care products in the U.S. As of December 31, 2006, our staff included approximately 51 sales, marketing and technical support representatives. These representatives principally focus on complex CLIA certified laboratories including clinical research laboratories, reference laboratories and public health laboratories. We continually educate our sales representatives on the technical, clinical and economic merits of our products. All sales to customers outside the United States are made through distributors or agents. We currently have distributors addressing the major markets in Europe and Middle East. In the future, we plan to add additional distributors to address India and potentially the major Asian markets. To support our commercial efforts in Europe, in 2006 we acquired the assets of Amplimedical S.r.L., a limited liability company, in Italy. This wholly-owned subsidiary operates as our primary European sales, marketing and technical support office. We closed our previous European sales and support office in The Netherlands following the acquisition of Amplimedical. We have built our own internal services organization. This field service organization provides initial installation of the NanoChip ® system, on-going technical support and warranty and maintenance work as needed. Collaborations and Strategic Arrangements We intend to continue entering into collaborations to expand applications of our technology platforms and to accelerate the commercialization of products. We will pursue additional collaborations in various forms, including research and development agreements, licensing agreements and joint ventures. These collaborations permit integration of the technologies and resources of our partners with our technologies, while allowing us to pursue diagnostics and other opportunities outside the scope of these collaborations. We are currently involved in the following corporate collaborations: Jurilab In a series of investments from July 2005 through June 2006, we invested approximately $3.0 million to purchase 29.7% of the outstanding stock in Jurilab LTD (“Jurilab”), a Finnish company that has assembled a large database of genetic markers by studying the genetic patterns of a founder population in East Finland. This unique database was constructed over the last twenty years providing novel insights to the correlation of genetic patterns as a prognosticator of disease. Our investment in Jurilab is an example of our desire to add proprietary content on top of our advanced diagnostic tools and thereby create unique solutions to evaluate and diagnose disease. The investment agreement provides us with an option to purchase the entire company at a not-to-exceed price through December 31, 2007. In May 2006, we entered into a collaboration agreement with Jurilab, where Jurilab would identify and validate new prognostic markers for Type II diabetes with certain milestone payments of up to approximately $1.2 million. As of December 31, 2006, we paid Jurilab approximately $715,000 for the completion of certain milestones under this agreement. Applied Biosystems Our license agreement with Applied Biosystems Inc. (Applied Biosystems), with the underlying patents expiring at various dates between 2010 and 2015, provided us approximately $6 million in revenues in 2006. In January 2006, we renegotiated our contract with Applied Biosystems to include additional rights to certain intellectual property and a modification to our manufacturing and know-how transfer agreement. Under the revised agreement, we were guaranteed minimum quarterly royalties through December 31, 2006; however, actual royalties exceeded the minimum guarantees. There are no longer any guaranteed minimums. Although we expect this relationship to continue into the foreseeable future this contract can be terminated by Applied Biosystems with a 180-day notice. In September 2006, we entered into an agreement to assign certain rights associated with our Applied Biosystems royalty agreement from the period of July 2006 through December 2011 to Drug Royalty Trust (“DRT”) for an upfront payment of $20.0 million. Under the agreement, we have guaranteed minimum royalty payments from Applied Biosystems to DRT. If the royalty payments fall below certain minimums in a given fiscal year, we are required to pay cash to DRT for the difference between the actual royalty payments from Applied Biosystems and the minimums. In addition, if royalty payments from Applied Biosystems are above certain thresholds for a given calendar year we will receive, in cash, a certain percentage of the amount above the threshold. FasTraQ Inc. In June 2005, we signed a letter of agreement with FasTraQ, Inc. (“FasTraQ”) for the development of a certain future product. Our Chief Executive Officer and Chairman of the Board, Mr. Birndorf, is a director and an investor in FasTraQ and our newest director, Dr. Heiner Dreismann, became CEO of FasTraQ in 2006. In October and December 2005 we amended this letter of agreement. As a result of this agreement and related amendments we made an initial non-refundable payment of $500,000 in 2005 to begin the initial development of this product. As of December 31, 2005, we expensed the initial $500,000. In February 2006, we converted this letter of agreement into two executed contracts, a Development and License Agreement and a Collaboration Agreement. In February 2006, we committed to provide FasTraQ up to an additional $500,000 in funding based on certain milestones, of which $200,000 was paid in 2006 and expensed into research and development. Princeton BioMeditech (“PBM”) Through our SynX acquisition, we were a party to a 2001 development and manufacturing agreement between SynX and PBM to jointly develop and market various point-of-care tests for certain biomarkers and protein targets. As of January 2006, we terminated all of our previous agreements with PBM and replaced them with renegotiated contracts. These new agreements include a manufacturing and distribution agreement and a development agreement. There were no payments between us and PBM associated with entering into these agreements and there were no minimum purchase requirements between the parties. We agreed to continue the joint development of a point-of-care product for diagnosis of CHF that incorporates PBM’s proprietary technology, our proprietary reagents and an exclusive license between us and Roche Diagnostics GmbH. PBM is responsible for the development of a reasonably priced instrument and for manufacturing of a CHF test that uses our reagents to determine the amount of target NT-proBNP present in a patient. We will fund a certain percentage of the development cost of the instrument, up to an agreed upon maximum amount. In addition, we are required to develop and manufacture the reagents used in the instrument and supply them to PBM. We are also responsible to conduct the testing of our reagents required to obtain regulatory approval to market them. The parties will share revenues associated with this point-of-care instrument and test with the majority of revenues being allocated to the party responsible for selling, marketing and distributing the instrument and test within a specific geographic territory. Each party will be responsible for its own manufacturing, sales and marketing expenses and both parties are required to provide each other a forecast of expected demand for each others product (reagents or instruments). We provided PBM with an option to purchase or to receive a nonexclusive license for certain biological markers for the incorporation into a future point-of-care instrument related to congestive heart failure, stroke or traumatic brain injury. We have agreed to negotiate in good faith commercially reasonable terms for such a license or supply arrangement. However, if we are unable to agree upon such terms PBM will pay Nanogen a certain royalty for the use of these markers. Pharmacogenetics Diagnostic Laboratory Beginning in July 2005, we have made a series of investments Pharmacogenetics Diagnostic Laboratory, LLC (“PGx”) a development stage research and development company. These investments totaled $500,000 as of December 31, 2006. We believe our ownership interest in PGx will provide us with access to technology related to pharmacogenetics. Fisher Scientific On August 3, 2006, we entered into research and development collaboration arrangements with Fisher Scientific International Inc., (“Fisher Scientific”) and Athena Diagnostic, a wholly-owned subsidiary of Fisher Scientific. In March 2006, we entered into an agreement to provide certain research services for the Abgene subsidiary of Fisher Scientific during 2007. We agreed to share certain technology and patent rights related to the development, manufacture and marketing of new molecular diagnostic products. Under these arrangements, Fisher Scientific has the option to provide up to $10 million in 2007 and 2008 for the research and development of infectious disease and molecular diagnostic tests that will be mutually agreed upon. These arrangements are included in non-binding general agreements, thus the obligation of the parties are subject to further negotiation and final terms of definitive collaboration agreements. Additional projects have yet to be identified and committed by both parties. HX Diagnostics We have been working with HX Diagnostics (“HX”) under an agreement signed in August 2006 to develop a point of care test for the detection of pandemic flu or other viruses. HX provided $1.3 million of funding for this project during 2006. Under the terms of the agreement, HX will have exclusive commercialization rights for a completed product to detect a pandemic flu while we will retain the distribution rights to detect other flu viruses. Our collaboration on this program formed the basis for the contract awarded to Nanogen by the Center for Disease Control (“CDC”) in December 2006. The CDC may provide funding for the next phase of this project and potentially beyond. Hitachi, Ltd., Nissei Sangyo Co. Ltd. and Hitachi Instruments Service Co. Ltd.—Research Agreement In 2000, we executed a research agreement with Hitachi, Ltd., Nissei Sangyo Co. Ltd. and Hitachi Instruments Service Co. Ltd. of Japan (collectively, “Hitachi”) to develop, manufacture and distribute potential products based on the parties’ proprietary technologies. Pursuant to the terms of the agreement, Hitachi and we each may contribute, toward our research and development efforts, cash over the period of the agreement. We are liable to repay to Hitachi 50% of all funding provided by Hitachi over an indefinite period of time. Repayment amounts are determined as a percentage of our gross NanoChip ® Cartridge sales until the liability is paid in full. In accordance with Statements of Financial Accounting Standards (“SFAS”) No. 68 “ Research and Development Arrangements ,” we recorded sponsored research revenue under this arrangement as expenses were incurred, in amounts not exceeding scheduled payments under the agreement. Sponsored research revenue recognized under this agreement totaled $500,000 for the year ended December 31, 2004. We had no revenue under this agreement in the years ended December 31, 2005 or 2006. Upon receipt of the funds, we recorded a long-term liability for 50% of the amount in “Other long-term liabilities” in the accompanying balance sheet, which accumulated to approximately $4.9 million as of December 31, 2006. . We have classified the entire balance of this liability as long-term due to the immaterial amount of current payments due under this obligation in 2007, as such payments are calculated under the agreement as percentage of gross NanoChip ® Cartridge revenue. In 2003, in accordance with the terms of the agreement, Hitachi exercised its right to terminate the collaborative research agreement. The termination of this agreement did not accelerate the repayment due Hitachi for the 50% of the funding. Based on discussions, we determined to focus our efforts on the development and manufacture of the NanoChip ® 400 instrument. Hitachi is responsible for world-wide manufacturing of the NanoChip ® system. We are responsible for development of assays and for marketing and sales. Government Grants National Institutes of Health (NIH) The National Institute of Allergy and Infectious Diseases for the NIH, provides funding for several grants. In July 2002, we were awarded a grant which focused on the development of a compact centrifugal micro fluidics based biological warfare agent (BWA) analyzer. In March of 2005 we began phase two of this grant and were awarded an additional $529,000 over a two year period. In May and September 2003, Nanogen was awarded a second and third grant. The second grant is for the development of a dieletrophorectic (DEP) separator for cell/pathogen separation. The third grant is aimed at developing an on-chip real-time DNA amplification for BWA detection. The total awards of these grants totaled approximately $1.5 million over a 4-year period. In July 2005, we were awarded a fourth grant for the diagnosis of Sepsis and community acquired pneumonia for a total of $2.5 million over five years. In September 2006, the Medical College of Wisconsin was awarded a five year $8.1 million grant, in which we are a subcontractor, to develop a rapid point-of-care diagnostic for bioterrorism “A” and pandemic influenza. Our expected share is $3.7 million as a subcontractor. Revenue is recognized under these grants as expenses are incurred and totaled $998,000, $650,000, $415,000 and $188,000 for the years ended December 31, 2006, 2005, 2004 and 2003, respectively. Bill and Melinda Gates Foundation Grant In July 2005, the University of Washington was awarded a $15.4 million grant from the Bill and Melinda Gates Foundation as lead partner of a consortium, which includes us, to develop a prototype portable device that healthcare workers could pack into remote regions to quickly and easily make life-saving diagnoses on such diseases as malaria. Our share over 5 years is expected to be $3.6 million. This consortium will concentrate on filling the need for an affordable portable device to do point-of-care testing and provide rapid results. Revenue under this grant is recognized as expenses are incurred and totaled $480,000 and $429,000 in the years ended December 31, 2006 and 2005, respectively. Center for Disease Control On December 4, 2006, we were one of four companies awarded a contract from the U.S. Centers for Disease Control and Prevention (“CDC”) to develop a unique multi-analyte point-of-care diagnostic assay for influenza in support of the US Government’s efforts to strengthen its readiness for a potential influenza pandemic. The goal of the project is to employ technology in a low cost, high sensitivity immunoassay that simultaneously detects Influenza Type A, Type B, seasonal flu and avian flu in a simple to use assay format. This development program is related to our partnership with HX Diagnostics, Inc. which will have the right to commercialize the product. The current award of $4.5 million funds the first two phases of a five-phase development project and, if all five phases are funded by the CDC, can total approximately $12.5 million over the next two to three years. Patents and Proprietary Technology Rights We consider the protection of our proprietary technologies and products to be an important element in the success of our business strategy. In 2006, we were granted 26 U.S. patents bringing our current total to 137 issued U.S. patents and numerous foreign patents expiring at varying dates. In addition, we have a number of pending patent applications filed in the U.S. and abroad. Patent applications may not be issued. Issued patents may not be found valid if challenged. In addition, intellectual property rights licensed by us may not be successfully integrated into commercial products. Others may independently develop similar technologies or duplicate any technology developed by us. Because of the extensive time required for development, testing, and regulatory review of a potential product, it is possible that, before new products can be commercialized, our related patents may expire or remain in existence for only a short period following commercialization, thus reducing any advantage of the patent, which could adversely affect our ability to protect future product development and, consequently, our business, financial condition and results of operations. We seek to protect our inventions through filing U.S. patents and foreign counterpart applications in selected other countries. Because patent applications in the U.S. are maintained in secrecy for at least eighteen months after the applications are filed and since publication of discoveries in the scientific or patent literature often lags behind actual discoveries, we cannot be certain that we were the first to make the inventions covered by each of our issued or pending patent applications or that we were the first to file for protection of inventions set forth in such patent applications. Our planned or potential products may be covered by third-party patents or other intellectual property rights, in which case continued development and marketing of the products would require a license. Required licenses may not be available to us on commercially acceptable terms, if at all. If we do not obtain these licenses, we could encounter delays in product introductions while we attempt to design around the patents, or could find that the development, manufacture or sale of products requiring these licenses is foreclosed. We may rely on trade secrets to protect our technology. Trade secrets are difficult to protect. We seek to protect our proprietary technology and processes by confidentiality agreements with our employees and certain consultants and contractors. These agreements may be breached, we may not have adequate remedies for any breach and our trade secrets may otherwise become known or be independently discovered by competitors. To the extent that our employees or our consultants or contractors use intellectual property owned by others in their work for us, disputes may also arise as to the rights in related or resulting know-how and inventions. Competition The medical diagnostics and biotechnology industries are subject to intense competition. Our competitors in the United States and abroad are numerous and include, among others, diagnostic, health care, pharmaceutical and biotechnology companies. Many of our competitors have substantially greater financial, technical, research and other resources and larger, more established marketing, sales, distribution and service organizations than we do. Moreover, many of our competitors offer broader product lines and have greater brand recognition than we do, and offer price discounts as a competitive tactic. In addition, there can be no assurance that competitors, many of which have made substantial investments in competing technologies, will not prevent, limit or interfere with our ability to make, use or sell our products either in the United States or in international markets. In the markets for clinical molecular diagnostic products, a number of companies including Roche, ABI, Celera Diagnostics, Luminex and Third Wave compete with us for product sales, primarily on the basis of technology, quality, reputation, accuracy, ease of use, price, reliability, the timing of new product introductions and product line offerings. In the point of care market, there are numerous competitors that offer rapid cardiac tests. In particular, Biosite currently has FDA-cleared tests and a large installed base of customers for cardiac rapid tests including CHF. In markets outside of the United States, other factors, including local distribution systems, complex regulatory environments and differing medical philosophies and product preferences, influence competition as well. Government Regulation Our micro-array instrumentation and ASR products are to be used only for research purposes or by CLIA-certified laboratories when developing and validating their own diagnostic tests. When we begin to distribute and manufacture products for non-CLIA laboratories and point-of-care customers, we are subject to additional FDA requirements such as pre-market applications. In March 2006, we received FDA clearance to begin marketing our NT-proBNP congestive heart failure product for use with human plasma. In the third quarter of 2005, we received an untitled letter from the Office of In Vitro Diagnostic Devise Evaluation and Safety (OIVD), a division of the FDA. The letter described the OIVD’s concerns that our microarray NanoChip ® systems and certain related ASRs might be construed as a medical device that requires a premarket notification/application. During the first quarter of 2006 we met with the FDA and made certain changes in our marketing materials and sales approach. In September 2006, the FDA published “Draft Guidance for Industry and FDA Staff: Commercially Distributed Analyte Specific Reagents (ASRs): Frequently Asked Questions” setting forth the FDA’s interpretation of the regulations governing the sale of ASR products. Subsequently, we received a second letter from the OIVD in which the FDA asserted that our microarray and multiplexed reagents require FDA pre-market review. In November 2006, we met with the FDA to discuss the second letter. As a result of these communications, we relabeled the NC400 for Research Use Only and have committed to the FDA to submit the NC400 and our assays to the agency for pre-market approval beginning in 2007. We believe that our real time ASR products are not subject to FDA pre-market review. If there is an unfavorable decision or action by the FDA in these matters, it could delay or prevent sales of our NanoChip ® 400 to clinical laboratories in the United States and could adversely impact sales of our ASRs to clinical laboratories in the United States. There can be no assurance that new legislation will not impose additional costs or lengthen review times for our products. Additionally, should we develop food pathogen products, they will be subject to the regulations of various domestic and foreign government agencies which regulate food safety and food adulteration, including the U.S. Department of Agriculture. Manufacturing and Raw Materials In July 2000, we executed a ten-year agreement with Hitachi, Ltd., Nissei Sangyo Co. Ltd. and Hitachi Instruments Service Co. Ltd. of Japan to develop, manufacture and distribute products based on the parties’ proprietary technologies. In June 2003, we entered into another manufacturing agreement with Hitachi for the manufacture of our second generation clinical instrument. Hitachi has exclusive manufacturing rights and distribution rights in Japan. We have retained exclusive rights pursuant to each agreement to manufacture the NanoChip ® Cartridges. Pursuant to the manufacturing agreements each party is obligated to provide the other with certain notice periods if such party determines to curtail or terminate the manufacturing relationship. Nevertheless, while alternative manufacturers of our NanoChip400 ® exist, a lengthy process would be required to negotiate and begin work under a manufacturing agreement with a new manufacturer which could disrupt our manufacturing process and harm revenues from NanoChip ® product sales. We purchase raw materials essential to our business in the ordinary course of business from numerous suppliers. Substantially all the raw materials used for our commercial manufacturing of oligonucleotides, assay systems and other reagent products are available from multiple sources; however, other raw materials for supply contract and OEM manufacturing are proprietary products of other companies. Raw materials may be rejected if they do not meet manufacturing specifications, are contaminated and/or have other failures. A material shortage, contamination, or failure could adversely impact the commercial manufacturing of our products and related revenues. Quality Systems We have implemented modern quality systems and concepts throughout the organization. Our regulatory department supervises our quality systems and is responsible for assuring compliance with all applicable regulations, standards and internal policies. Our senior management team is actively involved in setting quality policies and managing internal regulatory and monitoring external quality performance. Our regulatory, quality and government affairs department has successfully led us through multiple quality and compliance audits by regulatory bodies and customers. Geographic Area Financial Information For financial information concerning the geographic areas in which we operate, see Note 14, Geographic Sales and Significant Customers to the consolidated Financial Statements. Employees As of December 31, 2006, we had 288 employees of whom 39 hold Ph.D. degrees and 22 hold other advanced degrees. Approximately 79 are involved in research and development, 101 in operations, manufacturing and quality assurance, 64 in sales and marketing, and 44 in finance, legal and other administrative functions. Our success will depend in large part upon our ability to attract and retain employees. We face competition in this regard from other companies, research and academic institutions, government entities and other organizations. None of our employees are covered by a collective bargaining agreement except for our Italian employees that operate through government mandated workers councils. Item 1A. Risk Factors We have a history of net losses. We expect to continue to incur net losses and we may not achieve or maintain profitability. Since our inception, we have incurred cumulative net losses which, as of December 31, 2006, total approximately $360.7 million. Moreover, our negative cash flow and losses from operations will continue for the foreseeable future. We may never generate sufficient product revenue to become profitable. We also expect to have quarter-to-quarter fluctuations in revenues, expenses and losses, which could be significant. The amount and timing of product revenue recognition and cash flow may depend on whether potential customers for the molecular testing platform choose to enter into sales, reagent rentals, cost-per-test or development site transactions. We believe our future operating results may be subject to quarterly fluctuations due to a variety of factors, including, but not limited to, goodwill or other impairment charges, non-cash stock option expenses, market acceptance of the second generation NanoChip ® 400 System, acquisitions, and potential other products under development, including the CHF product and diagnostics related to infectious disease, the type of acquisition program our potential customers may choose, whether and when new products are successfully developed and introduced by us or our competitors, and the achievement of milestones under our collaborative agreements various government and private agencies. The recognition of revenue under contracts, grants and sponsored research agreements will be subject to significant fluctuations in both timing and amount and therefore our results of operations for any period may not be comparable to the results of operations for any other period. To develop and sell our products successfully, we may need to increase our spending levels in research and development, as well as in selling, marketing and administration. We may have to incur these increased spending levels before knowing whether our products can be sold successfully. We will need additional capital in the future. If additional capital is not available, we may have to curtail or cease operations. We will need to raise more money to continue the research and development necessary to further develop our current products to bring our products to market and to further our manufacturing and marketing capabilities. We may seek additional funds through public and private securities offerings, arrangements with corporate partners, borrowings under lease lines of credit or other sources. If we can not raise more money, we will have to reduce our capital expenditures, scale back our development of new products, significant reduce our workforce and seek to license to others products or technologies that we otherwise would seek to commercialize ourselves. The amount of money we will need will depend on many factors, including among others:   •   the amount of revenue we are able to generate;   •   the progress of our research and development programs;   •   the commercial arrangements we may establish;   •   the time and costs involved in:   •   scaling up our manufacturing capabilities;   •   meeting regulatory requirements, including meeting necessary Quality System Regulations (“QSRs”) and obtaining necessary domestic and international regulatory clearances or approvals;   •   acquisition(s) or investment(s) into other businesses;   •   filing, prosecuting, defending and enforcing patent claims and litigation; and   •   the scope and results of our future clinical trials, if any. Additional capital may not be available on terms acceptable to us, or at all. Any additional equity financing will be dilutive to stockholders, and debt financing, if available, may include restrictive covenants and require significant collateral. If our products are not successfully developed or commercialized, we could be forced to curtail or cease operations. We are at an early stage of development. As of December 31, 2006 we had only a limited product offering that includes real-time PCR products (both custom and proprietary tests), molecular testing platforms (NanoChip ® system), ASRs and the point-of-care diagnostic tests for myocardial infarction and drugs of abuse. Our congestive heart failure point of care test remains in development. Our second generation molecular testing platform, the NanoChip ® 400, began shipping in October 2005. Many of our ASRs are under development. Our molecular testing platforms and ASR products may not be successfully developed or commercialized on a timely basis, or at all. If we are unable, for technological or other reasons, to complete the development, introduction or scale-up of manufacturing of our new products, or if our products do not achieve a significant level of market acceptance, we would be forced to curtail or cease operations. We are also party to transactions known as reagent rentals and cost-per-test agreements. Under these types of transactions, we place molecular testing systems at a customer site with no upfront cost to the customer. The value of the instrument is typically recaptured through a contracted stream of future reagent sales, sold at a premium to cover the cost of the system. These reagent rentals and cost-per-test agreements result in us investing current capital in the cost of an instrument, while revenues recognized and cash received under these agreements are over the life of the contract, as reagents are shipped to the customer. Lack of market acceptance of our products and technology would harm us. Our success will depend upon our ability to continue to overcome significant technological challenges and successfully introduce our products into the marketplace. A number of applications envisioned by us may require significant enhancements to our basic technology platform. There can be no assurance that we can successfully develop such enhancements. Although we have developed a number of products a